§ Investors and firms can trade the same set of securities at
competitive market prices equal to the present value of
their future cash flows
§ There are no taxes, transaction costs, or issuance costs
§ A firm’s financing decisions do not change the cash flows
generated by its investments, nor do they reveal new
information about them
§ MM Proposition I:
In a perfect capital market, the total value of a firm’s
securities is equal to the market value of the total cash
flows generated by its assets and is not affected by its
choice of capital structure
§ MM and the Law of One Price
§ Without taxes or transactions costs, the total cash flow paid out
to all security holders is equal to the total cash flow generated
by the firm’s assets
§ Therefore, the value of a firm’s securities must equal the value
of its assets
§ Separation Principle – the choice of financing does not affect
the value of the firm
§ Homemade Leverage
§ What if investors prefer an alternative capital structure to the
one the firm has chosen?
§ MM show that investors can borrow or lend on their own, and
still the value of the firm will be unaffected
§ Homemade leverage (investors adjusting their portfolio
leverage) is a perfect substitute for the use of leverage by the
firm
§ The Market Value Balance Sheet
§ MM Proposition I applies to any choice of debt and equity
§ Market Value Balance Sheet – similar to an accounting balance
sheet, with two important distinctions
1. All assets and liabilities are included (reputation, brand
name)
2. All values are current market values (not historical)
§ Market value of equity
= MV of Assets – MV of Debt and other Liabilities
§ Leveraged recapitalization
§ Stage 1: Sell debt to raise cash
§ Stage 2: Use the cash to repurchase shares
§ The share price does not change – since the transactions are
zero-NPV transactions, they do not change the value for
shareholders
